Why frontier markets are outperforming emerging markets

Should investors seek shelter on the frontier from the storm engulfing emerging markets? Yes say experts as long as they choose their country carefully.
Marshall Stocker, Eaton Vance
Marshall Stocker, Eaton Vance

The Institute of International Finance (IIF) says frontier markets are outperforming emerging markets, as investors retreat under the onslaught of escalating trade wars, a strengthening dollar and rising interest rates.

In its latest forecast, published on September 20, the IIF says non-resident portfolio inflows to frontier market countries should rise to $145 billion in 2018, from $124 billion in 2017.

This is below the $152 billion the Washington-based trade group originally forecast at the beginning of the year, but still a good result considering the volatility and turbulence afflicting global markets.

However, the IIF also says the headline figures can be somewhat misleading since the rise can be attributed to one country, Qatar, which has benefitted from renewed inflows after a very difficult 2017.

Stripping Qatar out of the equation will leave frontier markets down 20% in 2018 it predicts. The biggest drop will be in debt flows, down one third from $30 billion to $20 billion.

But the IIF concludes that frontier markets will still end up in a better position than emerging markets, with inflows accounting for 5% of GDP in 2018 compared to 3% to 4% across bigger emerging markets.

Marshall Stocker, global macro equity strategist at Eaton Vance agrees. The Boston-based portfolio manager says country selection is key to getting frontier and emerging markets right.

Here he explains why Indonesia and the Philippines have been causing concern, while Vietnam should be front and centre of investors' minds for the right reasons and Bangladesh for the wrong ones. 

Q How are frontier markets holding up compared to emerging markets this year?

The MSCI Frontier Markets Index is down exactly three percentage points more than the MSCI Emerging Markets Index this year to date, but that’s thanks to one country: Argentina.

Today it accounts for about 15% of the index behind Kuwait and Vietnam, but at the beginning of 2018, Argentina’s weight was 24% of the index. And unfortunately, the Argentine peso has lost more than half of its value against the US dollar since the beginning of the year, leading to a 52% loss for the MSCI Argentina equity index through August.

Q Are frontier markets being impacted by the same challenging issues that emerging markets are facing: the strong dollar, trade wars and global reduction in central bank liquidity?

Actually no they’re not. Frontier markets are significantly less correlated to the global economy than emerging markets as a whole and that’s why it’s less sensible to overlay super-macro trends like these on top of them.

For example, a fair number of African countries aren’t plugged into global supply chains at all. Then in Asia, you have much more sharply contrasting exposure to global trade than emerging and developed markets.

Some countries, like Mongolia, are likely to suffer disproportionally if global growth slows. There’ll be less demand for the raw materials its economy depends on. Mongolia also has issues simply getting resources across the border. It desperately needs a better railroad into China, something which is being determined by local and regional politics, not any of the super-macro issues you describe.

Then at the other end of the scale is Vietnam, which should be a beneficiary of a Sino-US trade war. Multinationals have realised that their supply chains are far too concentrated in China and are shifting across the border. That process is likely to speed up. Samsung manufactures about 40% of its phones in Vietnam these days.

And the Middle East has generally been outperforming too. Oil prices are up and there’s a new generation of leaders in countries like Qatar and Saudi Arabia, which is creating some exciting headlines about prospects for economic reform.

But having said all that, it's clear that the dollar’s rally has had an impact. It’s the reason why a large number of frontier market equity markets are underwater in dollar terms. For example, the KSE 100 is still in positive territory, but not the Pakistan MSCI Index, which is down about 20% year-to-date.

Q Does it make sense for investors to shift from emerging markets to select frontier markets given their propensity for higher GDP growth?

It does, but the trend has been in the opposite direction for the past decade. Frontier markets got absolutely clobbered during the global financial crisis. The MSCI index lost half its value in 2008.

Since then fund managers have tended to view frontier markets as a good way to complement their emerging market exposure rather than as a stand-alone asset class. It’s partly because it’s still a very small investable universe compared to emerging markets and perhaps more importantly, it takes more time and effort to identify which countries to invest in.

Q And country selection is key?

Yes and there’s about four decades of academic and empirical evidence backing that approach up. Roughly 75% of excess returns are derived from picking the right country rather than the right sectors or stocks in a particular country.

So what matters to me is the general direction a country is taking, not so much what individual companies are up to. That applies across the whole of the emerging markets too.

Right now, investors are very focused on countries with macroeconomic vulnerabilities. But they're still showing some tolerance to those whose governments are trying to implement reform programmes.

That’s one reason why Indonesia and the Philippines are now under pressure following Turkey and Argentina’s woes.

Q What particularly don’t investors like?

In the Philippines they’re uncertain about the new central bank governor. One of the first things he did after taking office was to lower banks’ reserve requirement ratio. It signalled monetary loosening just as investors were expecting inflation to pick up.

And so it has come to pass. Inflation came in at 6.4% in August, above the government’s 2% to 4% target zone. It’s now at its highest level in nearly a decade.

Q What’s causing that?

In addition to the policy misstep, there have been some significant tax changes such as the introduction of TRAIN (Tax Reform for Acceleration and Inclusion) covering fuel and oil products, which have increased the price of goods and led to inflation.

Over the medium term, the Philippines is also likely to suffer some remittances-led pressures as well. Countries like Kuwait and Saudi Arabia are trying to reduce their reliance on imported labour and encourage their own population to take those jobs.

Q What’s the issue with Indonesia?

Indonesia has definitely been on the right track under President Jokowi [Joko Widodo] and it has a good finance minister in Sri Mulyani [Indrawati]. But the government is entering into an election cycle.

Hence it’s just announced that energy subsidies are likely to rise 52% this year to counter rising oil prices. That might be politically expedient over the short-term, but it’s detrimental to investor confidence.

Basically there are concerns whether this government is still committed to reforms to the same extent it was earlier on in its term.

Q Which Asian countries are you most positive about?

I like Kazakhstan, which has been hiring retired British judges to establish a commercial court system. But Vietnam is the standout. It’s the country investors should buy and hold for the rest of their lives.

The government’s reform programme has consistently moved in the right direction even though the pace has been frustratingly slow when it comes to lifting foreign ownership restrictions or divesting state-owned enterprises.

It’s like being stuck behind a little old lady who’s driving at half the speed limit. You just have to remember that she is, at least, going in the right direction and heading to the same place as you.

Q The market hasn’t done very well this year though. The Ho Chi Minh Stock Exchange Index dropped 25% between April and July.

It’s very hard to time these things especially in a frontier market country. Trading is still heavily dominated by local investors in Vietnam and will consequently be subject to sharp swings in value and sentiment.

The best strategy is to buy and forget because this is a market that will do very well over the next few decades. It should be a permanent fixture in anyone’s frontier or emerging markets portfolio.

Q What about the level of corruption? It’s the big negative when investors talk about Vietnam.

It’s an inescapable fact of life across all emerging market and frontier market countries and even developed ones. Again it comes down to what direction it’s heading in.

Investors realise excess returns when the absolute level of corruption decreases and transparency increases. In that respect, it’s always a good sign when you see countries starting to jail bank directors for clear transgressions. Vietnam is now doing that.

Q What’s your view on Myanmar where it's reporters that are being arrested and jailed?

This is a country where the economic policies are moving in the right direction, albeit from a low base and more slowly than expected. However, the great tragedy of what’s happening to the Rohingya people is creating one negative headline after another.

This crisis is occupying investors’ minds and distracting them from some of the positives such as the new company law, which has liberalised foreign ownership and improved the rule of law for commercial transactions.

The government has also been cautious about the amount of money it could end up spending on certain infrastructure projects and derisked them. It recently scaled back the $7.3 billion Kyauk Pyu deepwater port project on its Western coast to $1.3 billion to avoid falling into the same China-related debt trap as other countries along the Belt and Road.

Q Bangladesh appears to be going in the opposite direction to Vietnam even though it shares the same high growth rate (editor’s note: 7.86% in fiscal 2017/8). The government there is bailing out failing banks and not examining what’s going wrong.

Yes I’m deeply concerned about the banking system and lack of reform momentum generally.

For instance, the government announced that it was setting up a committee to improve the ease of doing business in the country. Yet we’ve not even been able to set up a meeting with a single committee member to try and understand what they hope to achieve.

It doesn’t inspire confidence. It’s a bit of an enigma how GDP and the garment industry continues to do so well, given the country’s history of hartels (editor's note: country wide strikes). I think it’s partly testament to the sheer robustness and industriousness of the private sector.

Q What about Pakistan, which appears to be on the verge of yet another IMF programme?

Yes that’s the 64 million dollar question. Will Pakistan turn to the IMF for the 22nd time since it became independent? It’s never popular domestically because the IMF always calls for austerity and frequently disrupts the gravy train.

The country appears to think it has three options: IMF, China, or trying to go it alone, which would be a really bad outcome.

The senior business leaders I’ve spoken to believe the IMF is essential. It will give the government cover to implement some of the more difficult reforms such as collecting taxes more efficiently.

What’s good is that we have seen some positive signs. The government just increased imported natural gas prices by 20% to address its budget woes.

Q Finally, what’s your view on Sri Lanka, the country that perennially holds so much promise?

It’s really been performing off cycle and plumbed the depths of GDP growth of late. The reform momentum is incredibly slow.

But I have a fairly positive view post the forthcoming presidential election in 2020, whoever wins. The current government has done some good things and the next administration needs to distil those further – improving the rule of law, reducing the size of government etc. Former administration officials say they support these policies.

Q But they weren’t the kind of policies that former president Mahinda Rajapaksa introduced when he was in office.

That’s why it’s important to make sure the policies match the rhetoric. There are plenty of examples of administrations, which have a very chequered first term followed by a better second one right across emerging and frontier markets.

It’s possible that the Rajapaksa family could come back and do things right if one of the other brothers wins the presidency. Peru is a very good example of this in action. Alan Garcia had a terrible first term in the late 1980s and a successful second one from 2006 to 2011.

So I have faith in Sri Lanka and it has a very good technocratic central bank governor who is trying to do all the right things as well.

Q On balance, how does Asia stack up compared to the rest of the frontier market universe you look at?

I have a lot more faith in Asia than South America, which seems to be caught in a Sisyphean trap of constantly swinging from good to bad and back again. Plenty of countries in Asia are steadily moving in the right direction nearly all of the time, even if the pace can be a bit frustrating for investors.

What I have to watch for are abrupt shifts such as a central bank governor making the wrong decision, an assassination, or geopolitical stand-off like the one when China set up an oil rig in disputed waters just off the Vietnamese coast in 2015.

There’s nothing about Asia that keeps me up at night. What I have to watch out for are the things that might wake me up.

¬ Haymarket Media Limited. All rights reserved.
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